Charles Montanaro has issued a warning to investors about the number of “crooks” running small caps, quipping you are now more likely to find them floating a stock on AIM than robbing a bank.
The Montanaro Asset Management founder specialises in small caps, noting that on average they have made 3.6 percentage points more than their larger counterparts on an annualised basis over the past 67 years. In addition, he said the lack of analyst coverage in this area made it easier to outperform the market.
However, he warned that this lower level of scrutiny also had its drawbacks, which was why experience was so important when investing further down the market-cap scale.
“Remember, crooks live in the world of small companies, and seasoned fund managers who have been round the block a few times have met more crooks,” the manager said.
“These days, there is no point in a criminal donning a balaclava and carrying a sawn-off shotgun to walk into a bank to demand loads of money. He probably wouldn’t be able to find a bank branch anyway. Far easier to put on a suit and tie (yes, standards please) and float a company on AIM.”
With Montanaro founded in 1991, the manager has met his fair share of chancers over his career. While he said it wasn’t always apparent they were up to no good, there were a number of red flags to watch out for, the most obvious being whether their company passed what he referred to as the “do you know what it does and how it makes money?” test.
One company that failed in this regard was Versailles Group, a FTSE 250 financial services company which listed on AIM in 1995. At the time, most brokers recommended Versailles as a “buy”.
However, Montanaro said that when UBS invited him to meet Cushnie in the late 1990s, his team was confused by Versailles’ business model, which was opaque and relied on offshore companies in a variety of tax havens.
When the team tried to recreate the parent company’s accounts using its subsidiaries, it found it couldn’t get the numbers to add up.
“At the meeting, we started to ask questions about these to try to understand where we were going wrong,” Montanaro explained.
“Cushnie stood up, shouted that he had never been treated so rudely before, and stormed out with Fred Clough his finance director. The broker told us we had offended him so much he would think twice about sending a company to see us. Obviously, we did not invest.”
Versailles listed on AIM in 1995 at 7.5p, then moved to the full list in October 1997. The shares peaked at £2.50 in September 1999 with a market capitalisation of £630m.
The problem was that the company was fraudulent and its subsidiaries either didn’t exist or were used to channel funds from one side of the business to the other.
“Clough spent his days making up fictitious clients and invoices,” Montanaro continued. “Apparently, he found it increasingly hard to come up with new names as the company got bigger and he needed to fabricate ever more invoices. An investigation found that from 1992 to the end of 1999, 80% of the reported turnover of £700m was completely made up.”
Cushnie and Clough were eventually jailed. Montanaro said the funny thing about this episode was that while his team’s questioning had obviously scared Cushnie and Clough, it hadn’t uncovered the fraud. Yet the episode highlighted a number of important points.
“Firstly, as I say repeatedly, the crooks live in the world of small cap, so be careful and invest in the best companies with management you can trust,” the manager said.
“Secondly, do not rely on brokers – do the work yourself; ask a lot of questions even if you think they may be stupid (they probably aren’t); make your own mistakes; only invest in businesses that you understand; and stay humble, as fraud can catch you out even if you do all the work.”
Of course, such scandals aren’t confined to small caps – a similar situation unfolded at Wirecard, which filed for insolvency in June 2020. The German payments processing company peaked at a market cap of $28bn (£20.9bn).
Yet Montanaro said the difference with small caps was that you have access to the management teams of the companies you invest in, many of whom are also founders.
“They take the decisions that will make or break the company,” he added. “You have to work out if they are crooks and where their attention is focused. It is a huge privilege that they give us their time. It is essential to meet them to see the whites of their eyes.”
Montanaro compared this with large-cap fund managers, many of whom have never met their holdings’ management teams. He described this situation as “extraordinary”: “Why pay active management fees to a fund manager who invests in companies that are so large they rely entirely on research notes of brokers, most of whom say largely the same thing?
“It makes more sense to take a passive approach such as an ETF for large caps. Would the CEO of Unilever ever meet us for a one-on-one meeting and tell us anything that the lawyers have not vetted first?”
He finished by highlighting the recent bout of volatility in the market, which has hit growth strategies – such as the ones he manages – particularly hard. At such moments he said it was important to stay calm and ignore the pessimists, pointing to a quote from Peter Lynch of Fidelity’s Magellan fund: “Far more money has been lost by investors preparing for market corrections than has been lost in the corrections themselves.”
Montanaro added: “Always remember that no one knows what the market is about to do. But in the case of UK small companies, if you stay invested for five years or more, even if you bought at the top, the chances are that you should still make money.”
Data from FE Analytics shows LF Montanaro UK Income has made 173.5% over the past decade, compared with gains of 107.2% from the IA UK Equity Income sector and 102.21% from the FTSE All Share.
Performance of fund vs sector and index over 10yrs
Source: FE Analytics
The £71m fund has ongoing charges of 0.8% and is yielding 2.8%.